This application is related, generally and in various embodiments, to financial indices and, more particularly, to systems and methods for constructing and maintaining a value index and a growth index representative of a group of securities.
A financial index is a statistical construct that measures price changes, returns, industry exposures, country exposures, interest rates and/or other financial data in stock markets, fixed income markets, currencies or futures markets. One use of an index is to provide a summary measure whose behavior is representative of the movements of prices or rates of a group of securities, and thus an indication of the behavior of a broad market. Another use of an index is to provide an unmanaged representation of an opportunity set that is representative of investment strategies followed by practitioners. Because indices serve as a barometer for the overall performance of a particular market, they are used as benchmarks against which investment results are measured as well as for implementing various investment strategies such as asset allocation, relative value analysis, and portfolio analysis. Furthermore, indices are often used as a basis for other products and strategies (e.g., derivative products) that provide investors with a convenient way of profiting from overall market movements. Examples of indices are the S&P 500, an equity index that tracks the performance of 500 publicly traded companies, and the J.P. Morgan Government Bond Index, a benchmark used for measuring performance and quantifying risk across international sovereign bond markets.
It is known to break down broad equity indices into various sub-segments that are defined on the basis of the characteristics of the securities that define the indices. Common types of segmentation include size and style. Segmentation of broad equity indices into various size and style sub-indices provides an opportunity for investors to enhance the performance of a total equity portfolio by varying exposure to specific market segments which have different characteristics and thus perform differently, and by allocating mandates to managers specializing in different market segments and investment styles.
Size segmentation involves defining sub-segments in an equity index based on the equity market capitalization of the securities that define the index. Most investors recognize four size segments: large capitalization, mid capitalization, small capitalization and micro capitalization. Style segmentation involves identifying a value segment and a growth segment based on the accounting, fundamental data, and market data of the securities that define the underlying index. While the method of defining size is relatively standard, the method of defining style is not. At a high level, value securities can be defined as securities of companies with lower than average valuation while growth securities can be defined as securities of companies with higher than average future growth prospects.
It is known to form equity style indices from a broad index by selecting a variable, or a set of variables aggregated in one score, according to which securities are ranked. This ranking is then used to split the broad index in halves that form a value index and a growth index. For example, in forming a value index and a growth index for a particular country stock index, the value of the price to book value ratio (P/BV where BV is the book value of equity in the company balance sheet) of each security can be used to rank the securities in order. Securities with a low price to book value ratio are considered to be value because the price paid for the value of the company measured by the book value is low while securities with a high price to book value ratio are considered to be growth. Starting with the security having the lowest price to book value ratio, the securities are added to the value index in increasing order of price to book value ratio until the market capitalization of the value index reaches one-half of the market capitalization of the particular country stock index. The remaining securities are then used to define the growth index.
Style indices formed in the above-described manner have several drawbacks. First, because such constructions rely on only one variable, the price to book value ratio, to determine whether a particular security is to be added to the value index, the relevancy of the resulting indices may be compromised due to data quality, differences in accounting practices from one country to another, lack of relevance of the variable for some industries, etc. Second, the one variable approach also proves to be relatively unstable through time and leads to style indices with significant turnover, an index characteristic that many practitioners consider undesirable. Third, by default, nonvalue securities are defined as growth securities. As a result of this one dimension approach (value or nonvalue), indices constructed in this manner can lead to relatively good value indices but the growth indices are not necessarily reflective of securities of companies with higher than average future growth prospects.
It is also known to form style indices using a two-dimensional approach and multiple variables to independently define value characteristics and growth characteristics of the securities that define the indices. Such constructions recognize that a given security may exhibit a value characteristic, a growth characteristic, a value-and-growth characteristic, or a nonvalue-and-nongrowth characteristic. This two-dimensional approach does not define growth as nonvalue. Rather, this approach uses variables more specific to growth investing to define growth, thereby improving the quality of the growth indices. In addition, the use of multiple variables leads to a more robust and meaningful style classification.
Although style indices constructed in this manner represent an improvement compared to the one variable and one dimension approach, they rely on an appropriate selection and combination of the variables to yield good results. For instance, some of these indices are constructed using only historical accounting data to characterize growth securities. Such constructions fail to accurately address the essence of growth investing, the estimation of future growth prospects. Other such indices are constructed using the price to reported earnings ratio (P/E) to characterize value securities. However, the price to reported earnings ratio can be very unstable due to the very nature of the reported earnings and as such can contribute to higher turnover in the resulting style indices.
Additional shortcomings of style indices constructed in this manner may include an unacceptable level of turnover due to a variety of reasons and a lack of reproducibility. The lack of reproducibility can often be attributed to nondisclosure or nontransparency of the various rules employed for aggregating the various variables into useful scores, for handling securities showing mixed characteristics (e.g., value-and-growth or nonvalue-and-nongrowth), and for allocating securities to the style indices.